Normally the Federal Reserve adjusts short-term interest rates to moderate the economic cycle. Even if short-term interest rates are very low, as they are at present, long-term interest rates are typically significantly higher. Recently the Fed implemented a new policy to reduce long-term interest rates to almost unprecedented levels. This policy proved to be very effective: the yield of long-dated US government bonds, i.e. the long-term interest rate, was at a 50-year low in late 2008 and is still very close to those levels.

This policy is partly an attempt to restart the housing bubble by lowering the rates for conventional 30-year mortgages, which are tied to the overall level of long-term interest rates. A recovery in housing, the Fed reasons, would lead to a recovery of consumer spending, which in turn would ‘fix’ the economy.

As we discussed in a recent article (“Fed Policy and Credit Bubbles” by D. Bourn and M. Gremm), encouraging consumer spending is a very short-sighted way of fixing the economy that will have highly undesirable consequences down the road. However, in addition to the problems discussed in that article, abnormally low long-term interest rates pose a much more immediate danger to bond investors: By forcing long-term interest rates down, the Fed has lifted bond prices, which are inversely related to long-term interest rates, into bubble territory.

This is not a problem if long-term interest rates stay at current levels, but if the government stimuli succeed and the economy recovers, long-term interest rates will have to increase to keep inflation in check. This will cause the bond bubble to pop and investors who bought at current prices will face dramatic declines of the value of their investments.

Investors who hold their bonds to maturity are likely to lose money on their investment due to inflation. Each bond has a yield to maturity, which is the return an investor who keeps the bond until it matures will realize. At current prices, 30-year government bonds yield about 3% per year. This guaranteed rate of return is normally the main appeal of bonds. However, inflation rates have historically averaged around 4%. Assuming that this continues to hold true for the next 30 years, investors who buy these bonds now and hold them to maturity will realize a loss of about 1% per year after adjusting for inflation.

Investors who do not intend to hold their bonds to maturity are exposed to a much more immediate risk. If the various stimulus packages succeed and the economy recovers, long-term interest rates will have to increase to keep inflation in check. This will cause a steep decline in the market price of bonds. An investor who sells after the decline has taken place may face substantial losses.

Two of the largest historical declines in the market value of bonds occurred in 1994 and 1999. The value of the Ibbotson long-term government bond index declined 14% in 1994 as long-term interest rates increased from 6.5% to 8%. In 1999 interest rates increased from 5.4% to 6.8% resulting in another 14% decline. The present situation will most likely lead to much larger losses.

In order to compare the present situation with these historical periods we will consider various scenarios for a specific US government bond. We will focus on the 30-year bond with a coupon payment of 4.75% that matures on 2/15/38, which traded at about $1269 on 1/20/09. The yield to maturity (investment return if held to maturity) was 2.986% per year. In order to see how the price of this bond may evolve in the future, we will consider several interest rate scenarios that assume an economic recovery and one deflationary scenario.

The most likely scenario is that the government stimuli succeed and interest rates return to more normal levels as the economy and inflation pick up. If rates return to 5%, still a low yield for a 30-year US treasury, the value of our bond would decline about 29% to $900. The last time this bond traded near such valuations was only about 7 months ago.

Normally when the Fed floods the economy with money, inflation picks up quickly once the recovery begins. If this happens this time around, interest rates may need to be around 8% or higher to contain the problem. Yields in this range are quite plausible. They were the norm for the period from the mid ’70s to the mid ’90s. At 8% the bond would be worth about $590, which is a 54% decline from its present value. To put this into context, the S&P 500 declined about 47% from its May 2008 high to its November 2008 low and the declines in our historical examples were only about 14%.

A decline of this magnitude would have enormous repercussions. Supposedly safe bond portfolios held by pension funds, trusts, foreign countries (especially China), and individuals would be cut in half. Such drastic price changes are expected for stock portfolios, but for bonds price moves of this magnitude would be unprecedented.

On the other hand, there is one scenario that makes current bond prices look attractive. If the government stimuli fail, we may enter into a long deflationary period. If this happens, long-term interest rates will stay at present levels or continue to decline. If yields were to decline to 2%, the lowest they have ever been, the value of the bond would change to $1569, corresponding to a 24% increase in value. Investors buying bonds are current levels are speculating on long-term deflation, a low probability event with limited payout since interest rates can’t go below zero, but substantial risk since there is no limit to how high they can go.

We believe that over the 30 year life of the bond the economy will recover even if there is a deflationary period in our immediate future. Consequently long-term investors who buy bonds at present prices will most likely have to choose between holding the bond to maturity and watching the purchasing power of their investment erode due to inflation, or selling it at a steep loss due to higher prevailing interest rates at the time of the sale.

There is a certain irony in the fact that an investor who believes that the economy will recover would be unwilling to lend money to the US government at currently prevailing rates (i.e. buy a bond at market price), while an investor who believes that the stimuli will fail and that we are facing 30 years of deflation would be happy to fund as many stimulus programs as the government cares to put on.